Debris blocks a coastal inlet near Sendai, Japan, March 14, 2011. Photo Credit: U.S. Air Force
-- This is a guest post by Jay Pelosky, Principal, J2Z Advisory, LLC -- Japan’s massive earthquake, follow on tsunami and subsequent nuclear power plant upheaval have reinforced uncertainty regarding the strength of global economic activity and the appropriate financial assets prices to reflect that activity. The Arab Spring and EU debt crisis meant such uncertainty was already in the air in the weeks preceding the March 11th earthquake. Investors, even more than policy makers, hate uncertainty – the textbook financial market response over the past 10 days has been to sell risky equities and buy safe government bonds. Such a response should surprise no one.
One can argue that a correction in global equity prices makes great sense given the one way nature of their rise since last Fall. The concurrent rise in bond prices also seems appropriate given their parallel sell off over the past 3-4 months. This is especially true in the US, where falling rates may help breathe some life into the moribund housing market. The depth and degree of financial asset price moves does however lead one to wonder if investors have discounted the full story. For example, if one was to posit in early January say, that in the space of one week Japan’s three disasters would occur, Saudi Arabia would send troops to Bahrain to help quell protests there and European policy makers would fudge another shot at debt resolution and yet the financial asset price outcome would be limited to (ex Japan assets) modest sell offs in equities and rallies in government bonds, with gold little changed and oil up a bit, the response would be seen as quite limited.
This then begs the question of what it is exactly financial markets have discounted? Is it Japan alone? Is the Middle East situation included as well? What about European debt? How much of these financial asset price moves reflect considered thought for the 2011-12 ramifications of these three combined? When one considers the muted response to date in terms of global economic forecast adjustments, it would seem very little has been fully considered. Investors are notably poor at discounting natural disasters while policy makers and intelligence agencies seem equally poor at discounting political upheaval and revolution. When the environment combines the two, as we have today, it suggests deeper discounting might well be required.
The investment world, like much of our social and political worlds, has been hollowed out over the years. Investors today seem to face a choice between flash trading and sitting on the sidelines, frozen by fear. In my investing practice, I seek to find middle ground, a process of portfolio evolution rather than frenzy or statis. Employing a global framework, assessing whether a crisis requires that framework to be tweaked, left alone or abandoned is critical to be being able to play offense. Macro crises should be viewed as opportunities, opportunities to buy and sell assets whose prices have become unmoored from their fundamentals as a result of panic selling, selling often exacerbated by risk models that shout “severe risk aversion”, usually well after the horse has left the barn. Examples of such opportunities over the past ten days would include increasing exposure to Japanese small caps, US based tech and energy stocks and the S&P while reducing US Treasury exposure into its rally.
Japan’s global economic and financial market impact, for all the intense focus today on its nuclear reactors, is likely to taper off in the near term. Someday soon, clarity will be delivered on the status of its reactors. G7 coordinated intervention (its first in a decade) on the yen signals policy makers are broadly willing to support Japan’s export economy over the near term. Nonetheless, over the course of this year, supply chain constraints and power shortages are likely to impede its economic recovery. Japan is likely to act as a drag on global economic activity this year while quite possibly providing a welcome boost to global growth in 2012.
Perhaps more important to global growth and asset prices over the next 12-18 months will be the evolution of events in Europe and the Middle East. Europe may well face a hot “summer of discontent” this year as political limitations, primarily German based, generate insufficient responses to the debt crisis which in turn manifest themselves in weaker economic growth, higher unemployment and rising social pressures. With youth unemployment above 40% in some countries, fiscal austerity biting hard and a strengthening currency, I am not optimistic on European economic growth or equity prices. The upcoming summit on March 24-25 will most likely be yet another example of political impotence, a disease breaking out all through the West.
It is the Middle East though that generates the greatest uncertainty, expressed mainly through the price of oil. As that price climbs well over $100 per barrel it spells weaker demand in the consumer driven West and rising inflation in the emerging economies, a toxic combination. The UN Security Council resolution on Libya suggests one should think about the action there as a firebreak or a timeout to allow the West to help craft a political resolution to the demand for reform in Bahrain. Home to the US 5th Fleet and close to the oil heart of Saudi Arabia, further upheaval there could spark sharply higher oil prices. Such an event could cause the macro framework noted above to require substantial reset. The world remains bifurcated, split between a slow growing, highly indebted and rapidly aging West and a fast growing, young, emerging world facing rapidly rising food/fuel based inflationary pressures that threaten social and political stability. The combined implications of Japan, the EU and the Middle East are to further enhance this bifurcated state, with risks rising on both sides.
Japan’s nuclear crisis coupled with Germany’s decision to shut several of its nuclear plants will push up the price of natural gas, coal and oil. Middle Eastern political uncertainty will keep oil prices higher for longer, further weakening global growth prospects while putting more pressure on emerging economies via inflation. Failure to resolve the EU debt crisis will slow growth there while the German export machine may well falter in the face of an appreciating Euro. US growth forecasts are likely to be marked down as gasoline rises past $4 per gallon and the summer driving season begins. The need to balance state budgets in the US will also feature as a growth impediment as the year progresses with the recent Ohio state budget providing a glimpse of what is to come with its call for local funding cuts of 25% in FY 2012 ( begins July) followed by 50% cuts in FY2013. The political and social implications for the US are substantial.
The global fault line between a healthy stock market correction to be bought and a more severe market decline to be sold remains the emerging economies’ policy response to rising inflation pressures. (See Inflation: the Double Edged Catalyst). Emerging economies have a choice of policy responses – one method to cool inflationary pressures would be to allow the currency to rise, this is especially true in the case of China. The other option is to use the blunt instrument of interest rate hikes to cool off the domestic economy. The latter option runs the risk of policy mistakes and hard landings, quite possibly removing the world’s only source of sustainable end demand and setting up a much weaker global growth profile for 2012-13 than most expect today.
If the view that Japan’s 2012 growth profile will be robust relative to recent history is correct, then Japan could be a financial market safe haven offering as it does some of the world’s best values, especially in the small cap space. Yen weakness, the natural follow on to G7 intervention, would further support the Japan equity case. US equities remain the best way to play the globalization of demand theme and further weakness, to be expected given the need to discount the full effects of weaker growth, should be used to add to exposure. On a sector basis, tech stock weakness prior to the earthquake was a telling sign that stocks were in a correcting mode; for appreciation potential to manifest itself in US equities, sectors other than energy need to do well and tech should be a big part of that. Emerging economies and their stock markets remain too exposed to rising inflation to suggest adding here though USD emerging market debt and other spread product look appealing as yields have yet to follow US Treasury (UST) rates lower. There is a reasonable chance that UST rates can continue to fall as US economic growth fails to deliver and a move to 3% in the 10 year UST is not out of the question. The discounting of Japan’s woes is mostly complete; the discounting of its follow on issues coupled with EU and ME uncertainty is not.